BoAML | Turning to the long term outlook, we still expect that leaving the EU will worsen the UK’s trading terms with EU countries more than it improves trading terms with other countries. Assuming this thesis proves correct, it will come with economic costs. The recent better-than-expected data tell us nothing about that judgment, but political events suggest to us that it is on track. PM May has committed to triggering formal Article 50 EU exit procedures no later than the end of March 2017, in line with our expectations. Article 50 provides a two-year period for the UK to negotiate its terms of exit with the EU. The timeline can be extended if all other 27 EU states agree, which seems unlikely. On the face of it this means the UK will most likely formally exit the EU in early 2019. Some commentators have noted that the structure of Article 50 procedures will undermine UK bargaining power.
The question is what will the terms of exit be for the UK? PM May’s recent statements put immigration control and freedom from EU courts ahead of securing good trade terms from negotiations. Meanwhile, Brexit Minister David Davis’ parliamentary aid stated four red lines: “no contribution to the budget; no jurisdiction for the European Court of Justice; the end of free movement; and British laws being made in our sovereign Parliament.” Some observers had argued that German business would force compromise from Angela Merkel. We disagreed (see here, for instance). The newsflow suggests to us a tough stance from Angela Merkal, German business, and other EU states.
So our base case for the long-term UK outlook is unchanged. We expect tough negotiations leading to the UK and the EU eventually agreeing a free trade deal. That would mean no/few goods tariffs but reintroducing non-tariff barriers like customs procedures. They are often the largest impediment to trade, particularly for services. Accordingly, we continue to expect Brexit to detract a modest 2.5% from UK GDP in the long term (external estimates point to a bigger impact: see ‘Brexit and the markets’).
Our base-case assumption would probably be termed a “hard Brexit” by some observers. We think the risks of a worse outcome than that have risen. A worse outcome, a “very hard Brexit” say, could involve moving to the bare minimum trading rules: World Trade Organisation rules (WTO). That could happen as a result of failed negotiations or if the UK and EU could not reach a transitional agreement to cover the period between EU exit and the implementation of a trade deal. A transitional agreement would likely be needed because it can take well over two years to agree to a trade deal.
What about offsets from deregulation and trade deals?
We thought it unlikely that long-term Brexit costs could be offset by deregulation or by trade deals with non-EU countries. We think the newsflow has supported our judgment. The recent Conservative Party Conference, for instance, suggests the government may increase red tape (on immigration, for instance) rather than cut it. On trade, the UK will be unable to agree new trading relationships with other countries until it has left the EU customs union. That might not happen in 2019 if the UK agrees a transitional arrangement with the EU. This is one reason why the risks of a “very hard Brexit” are rising in our view: since any alternative would further delay the government’s aim of signing trade deals with other countries. Even once discussions with othercountries begin – which might take a long time with bigger nations like the US – trade deals could take a considerable time to achieve.
Moreover, in contrast to Trade Minister Liam Fox’s view that the UK is entering a ‘post geography trading world’, we continue to think the laws of gravity apply to trade. “There is very little that economists fully understand about global trade but there is one thing that we do know – commerce declines dramatically with the distance” (Leamer, 2007). So trade deals with other countries will not, we think, offset worse EU trading terms.